UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10‑Q
☒ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period September 30, 2019
or
☐ Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from to
Commission File Number 001-38084
FARMERS & MERCHANTS BANCORP, INC.
(Exact name of registrant as specified in its charter)
Ohio
34-1469491
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
307 North Defiance Street, Archbold, Ohio
43502
(Address of principal executive offices)
(Zip Code)
(419) 446-2501
Registrant’s telephone number, including area code
(Former name, former address and former fiscal year, if changed since last report.)
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
Trading Symbol(s)
Name of Each Exchange
Common Stock, No Par Value
FMAO
NASDAQ Capital Market
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or Section 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
☐
Accelerated filer
☒
Non-accelerated filer
Smaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐
Indicated by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ☐ No ☒
Indicate the number of shares of each of the issuers’ classes of common stock, as of the latest practicable date:
11,137,014
Class
Outstanding as of October 25, 2019
1
Washington, D.C. 20549
FORM 10Q
INDEX
Form 10-Q Items
Page
PART I.
FINANCIAL INFORMATION
Item 1.
Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets -September 30, 2019 and December 31, 2018
3
Condensed Consolidated Statements of Income - Three and Nine Months Ended September 30, 2019 and September 30, 2018
4
Condensed Consolidated Statements of Comprehensive Income - Three and Nine Months Ended September 30, 2019 and September 30, 2018
5
Condensed Consolidated Statements of Changes to Stockholders’ Equity - Three and Nine Months Ended September 30, 2019 and September 30, 2018
6-7
Condensed Consolidated Statements of Cash Flows - Nine Months Ended September 30, 2019 and September 30, 2018
8-9
Notes to Condensed Consolidated Financial Statements
10
Item 2.
Management's Discussion and Analysis of Financial Condition and Results of Operations
45-62
Item 3.
Qualitative and Quantitative Disclosures About Market Risk
63
Item 4.
Controls and Procedures
64
PART II.
OTHER INFORMATION
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Mine Safety Disclosures
Item 5.
Other Information
Item 6.
Exhibits
65
Signatures
66
101.INS
XBRL Instance Document (1)
101.SCH
XBRL Taxonomy Extension Scheme Document (1)
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document (1)
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document (1)
101.LAB
XBRL Taxonomy Extension Label Linkbase Document (1)
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document (1)
(1)
Pursuant to Rule 406T of Regulation S-T, the interactive Data Files in Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
2
ITEM 1 FINANCIAL STATEMENTS
FARMERS & MERCHANTS BANCORP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands of dollars)
September 30, 2019
December 31, 2018
(Unaudited)
Assets
Cash and due from banks
$
103,188
37,492
Federal funds sold
11,404
873
Total cash and cash equivalents
114,592
38,365
Interest-bearing time deposits
4,554
4,019
Securities - available-for-sale
190,465
168,447
Other securities, at cost
5,789
3,679
Loans held for sale
606
495
Loans, net
1,151,937
839,599
Premises and equipment
25,990
22,615
Goodwill
47,340
4,074
Mortgage servicing rights
2,556
2,385
Other real estate owned
351
600
Bank owned life insurance
15,151
14,884
Other assets
15,549
17,001
Total Assets
1,574,880
1,116,163
Liabilities and Stockholders' Equity
Liabilities
Deposits
Noninterest-bearing
261,719
215,422
Interest-bearing
NOW accounts
430,646
298,254
Savings
310,667
227,701
Time
274,996
187,413
Total deposits
1,278,028
928,790
Federal funds purchased and securities sold under agreements to
repurchase
30,056
32,181
Federal Home Loan Bank (FHLB) advances
24,669
-
Dividend payable
1,657
1,379
Accrued expenses and other liabilities
13,062
10,526
Total liabilities
1,347,472
972,876
Commitments and Contingencies
Stockholders' Equity
Common stock - No par value 20,000,000 shares authorized; issued and
outstanding 12,230,000 shares 9/30/19, 10,400,000 shares 12/31/18
81,264
10,823
Treasury stock - 1,092,986 shares 9/30/19, 1,114,739 shares 12/31/18
(12,453
)
(12,409
Retained earnings
157,126
147,887
Accumulated other comprehensive income (loss)
1,471
(3,014
Total stockholders' equity
227,408
143,287
Total Liabilities and Stockholders' Equity
See Notes to Condensed Consolidated Unaudited Financial Statements.
Note: The December 31, 2018, Condensed Consolidated Balance Sheet has been derived from the audited Consolidated Balance Sheet as of that date.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands of dollars, except per share data)
Three Months Ended
Nine Months Ended
September 30, 2018
Interest Income
Loans, including fees
15,202
10,725
46,605
31,348
Debt securities:
U.S. Treasury and government agencies
972
613
2,501
1,848
Municipalities
190
275
612
845
Dividends
69
56
233
164
120
(8
319
Other
459
92
887
219
Total interest income
17,012
11,753
51,157
34,426
Interest Expense
3,654
1,611
9,606
4,319
Federal funds purchased and securities sold under
agreements to repurchase
201
134
527
376
Borrowed funds
257
20
813
60
Total interest expense
4,112
1,765
10,946
4,755
Net Interest Income - Before Provision for Loan Losses
12,900
9,988
40,211
29,671
Provision for Loan Losses
247
47
410
Net Interest Income After Provision For Loan Losses
12,653
9,941
39,801
29,452
Noninterest Income
Customer service fees
1,722
1,392
4,994
4,323
Other service charges and fees
1,179
1,097
3,311
3,149
Net gain on sale of loans
260
184
558
617
Net gain (loss) on sale of available-for-sale securities
(26
Total noninterest income
3,161
2,683
8,837
8,099
Noninterest Expense
Salaries and wages
4,158
3,391
12,300
9,926
Employee benefits
1,331
1,029
4,148
3,013
Net occupancy expense
630
478
1,911
1,306
Furniture and equipment
720
588
2,179
1,660
Data processing
482
364
2,157
1,000
Franchise taxes
248
243
735
710
ATM expense
416
327
1,281
Advertising
587
236
1,229
669
Net loss on sale of other assets owned
22
17
FDIC assessment
81
194
249
Mortgage servicing rights amortization
149
84
329
264
Consulting fees
196
179
404
467
Other general and administrative
1,667
1,125
4,897
3,151
Total noninterest expense
10,606
8,126
31,829
23,404
Income Before Income Taxes
5,208
4,498
16,809
14,147
Income Taxes
933
623
3,130
2,391
Net Income
4,275
3,875
13,679
11,756
Basic and Diluted Earnings Per Share
0.38
0.42
1.23
1.27
Dividends Declared
0.15
0.14
0.45
0.41
See Notes to Condensed Consolidated Unaudited Financial Statements
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other Comprehensive Income (Loss) (Net of Tax):
Net unrealized gain (loss) on available-for-sale
securities
841
(617
5,651
(3,432
Reclassification adjustment for (gain) loss on sale of
available-for-sale securities
(10
26
(627
5,677
(3,442
Tax expense (benefit)
176
(132
1,192
(723
Other comprehensive income (loss)
665
(495
4,485
(2,719
Comprehensive Income
4,940
3,380
18,164
9,037
[ Remainder of this page intentionally left blank ]
Farmers & Merchants Bancorp, Inc. and Subsidiaries
CONDENSED Consolidated StatementS of Changes TO Stockholders’ Equity
For the THREE AND NINE Months Ended SEPTEMBER 30, 2018
(000’s Omitted, Except Per Share Data)
Accumulated
Shares of
Total
Common
Treasury
Retained
Comprehensive
Stockholders'
Stock
Earnings
Income (Loss)
Equity
Balance - January 1, 2018
9,265,880
11,546
(12,160
136,547
(1,826
134,107
Net income
3,767
Other comprehensive loss
(1,952
Adoption of ASU 2018-02
360
(360
Issuance of 100 shares of restricted stock
100
(16
(12
Stock-based compensation expense
160
Cash dividends declared - $0.13 per share
(1,193
Balance - March 31, 2018
9,265,980
11,690
(12,158
139,483
(4,138
134,877
4,114
(272
Forfeiture of 600 shares of restricted stock
(600
(2
(28
(13
154
Cash dividends declared - $0.14 per share
(1,284
Balance - June 30, 2018
9,265,380
11,842
(12,186
142,330
(4,410
137,576
Purchase of Treasury stock
(10,999
(490
Issuance of 32,900 shares of restricted stock
(Net of Forfeitures - 2,020)
30,880
(1,436
267
1,154
(15
183
(1,287
Balance - September 30, 2018
9,285,261
10,589
146,072
(4,905
139,347
6
For the THREE AND NINE Months Ended SEPTEMBER 30, 2019
Balance - January 1, 2019
3,224
Other comprehensive income
1,402
Issuance of 1,830,000 shares of common stock in acquisition
1,830,000
70,437
(6,558
(213
Issuance of 400 shares of restricted stock
(Net of Forfeitures - 2,040)
(1,640
(58
9
434
Cash dividends declared - $0.15 per share
(1,654
Balance - March 31, 2019
11,107,063
81,760
(12,680
149,466
(1,612
216,934
6,180
2,418
Forfeiture of 880 shares of restricted stock
(880
38
(27
13
157
(1,655
Balance - June 30, 2019
11,106,183
81,955
(12,707
153,993
806
224,047
(6,569
(165
Issuance of 37,700 shares of restricted stock
(Net of Forfeitures - 300)
37,400
(925
419
515
234
(1,657
Balance - September 30, 2019
7
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Cash Flows from Operating Activities
Adjustments to reconcile net income to net cash from operating activities:
Depreciation
1,980
1,406
Amortization of available-for-sale securities, net
579
743
Amortization of servicing rights
Amortization of core deposit intangible
546
126
Net amortization (accretion) of fair value adjustments
(1,530
825
497
Deferred income taxes
(200
Provision for loan loss
Gain on sale of loans held for sale
(558
Originations of loans held for sale
(50,428
(40,814
Proceeds from sale of loans held for sale
48,543
39,435
Loss on sale of other assets owned
(Gain) loss on sales of securities available-for-sale
Change in other assets and other liabilities, net
5,750
(3,450
Net cash provided by operating activities
20,016
9,577
Cash Flows from Investing Activities
Activity in available-for-sale securities:
Maturities, prepayments and calls
34,384
Sales
11,100
6,781
Purchases
(44,936
(9,416
Activity in other securities, at cost:
237
Change in interest-bearing time deposits
(535
(1
Proceeds from sale of other assets owned
371
Additions to premises and equipment
(2,805
(1,803
Loan originations and principal collections, net
(51,240
(14,536
Acquisition of Limberlost, net of cash received
(2,089
Net cash used in investing activities
(55,513
(7,213
Cash Flows from Financing Activities
Net change in deposits
142,853
9,519
Net change in federal funds purchased and securities sold under agreements
to repurchase
(2,125
(12,469
Repayment of FHLB advances
(23,938
Purchase of treasury stock
(378
Cash dividends paid on common stock
(4,688
(3,670
Net cash provided by (used in) financing activities
111,724
(7,110
Net Increase (Decrease) in Cash and Cash Equivalents
76,227
(4,746
Cash and Cash Equivalents - Beginning of year
34,467
Cash and Cash Equivalents - End of period
29,721
(continued)
8
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (Continued)
Supplemental Information
Cash paid during the year for:
Interest
9,962
4,706
Income taxes
2,345
2,407
Noncash investing activities:
Transfer of loans to other real estate owned
187
68
The Company purchased all of the capital stock of Limberlost for $78,902 on January 1, 2019. In conjunction with the acquisition, liabilities were assumed as follows:
Fair value of assets acquired
336,380
Less: common stock issued
Cash paid for the capital stock
8,465
Liabilities assumed
257,478
ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS
NOTE 1 BASIS OF PRESENTATION AND OTHER
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions for Form 10Q and Rule 10-01 of Regulation S-X; accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments, consisting of normal recurring accruals, considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2019 are not necessarily indicative of the results that are expected for the year ended December 31, 2019. The condensed consolidated balance sheet of the Company as of December 31, 2018, has been derived from the audited consolidated balance sheet of the Company as of that date. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2018.
The Company recognizes revenues as they are earned based on contractual terms, as transactions occur, or as services are provided and collectability is reasonably assured. The Company’s principal source of revenue is interest income from loans and investment securities. The Company also earns noninterest income from various banking and financial services offered primarily through Farmers & Merchants State Bank. Interest income is primarily recognized on an accrual basis according to nondiscretionary formulas written in contracts, such as loan agreements or investment security contracts. The Company also earns noninterest income from various banking and financial services provided to business and consumer clients such as deposit account, debit card, and mortgage banking services. Revenue is recorded for noninterest income based on the contractual terms for the service or transaction performed.
Reclassification
Certain amounts in the 2018 condensed consolidated financial statements have been reclassified to conform with the 2019 presentation. These reclassifications had no effect on income.
NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE
On January 1, 2019, the Company acquired Limberlost Bancshares, Inc. (“Limberlost”), the bank holding company for Bank of Geneva, a community bank based in Geneva, Indiana. Bank of Geneva operated six full-service offices in the northeast Indiana communities of Geneva, Berne, Decatur, Monroe, Portland and Monroeville. Shareholders of Limberlost received 1,830 shares of FMAO common stock and $8,465.00 in cash for each share. Limberlost had 1,000 shares outstanding on January 1, 2019. The share price of Farmers & Merchants Bancorp, Inc. (FMAO) stock on January 1, 2019 was $38.49. Total consideration for the acquisition was approximately $78.9 million consisting of $8.5 million in cash and $70.4 million in stock. As a result of the acquisition, the Company will have an opportunity to increase its deposit base and reduce transaction costs. The Company also expects to reduce costs through economies of scale.
In 2018, the Company incurred $742.1 thousand of third-party acquisition-related costs. The largest portion of the expenses recognized in 2018 related to consulting fees of $340 thousand, other general and administration expenses of $331.5 thousand and data processing expenses of $58.6 thousand. These three categories of expense accounted for 98.4% of the total acquisition expenses impacting the 2018 financial statements of the Company.
In 2019, the Company has incurred additional third-party acquisition-related costs of $1.27 million. These expenses are comprised of data processing of $867.6 thousand, employee benefits of $156.6 thousand, ATM expense of $31.4 thousand, consulting fees of $19.3 thousand and other general and administrative expense of $195.4 thousand in the Company’s consolidated statement of income for the nine months ended September 30, 2019.
Under the acquisition method of accounting, the total purchase is allocated to net tangible and intangible assets based on their current estimated fair values on the date of acquisition. Of the total purchase price of $78.9 million, $3.9 million has been allocated to core deposit intangible included in other assets and will be amortized over seven years on a straight line basis. Goodwill of $43.3 million resulting from the acquisition consists largely of the synergies and economies of scale expected from combining the operations of the Company and Bank of Geneva. Of that total amount, none of the purchase price is deductible for tax purposes. The following table summarizes the consideration paid for Bank of Geneva and the amounts of the assets acquired and liabilities assumed recognized at the acquisition date.
ITEM 1 NOTES TO CONDENSED CONSOLIDATED UNAUDITED FINANCIAL STATEMENTS (Continued)
NOTE 2 BUSINESS COMBINATION AND ASSET PURCHASE (Continued)
Fair Value of Consideration Transferred
(In Thousands)
Cash
Common Shares (1,830,000 shares)
78,902
Recognized amounts of identifiable assets acquired and liabilities assumed
Cash and cash equivalents
6,376
17,494
2,347
257,183
2,538
43,266
7,176
Total Assets Purchased
Noninterest bearing
37,822
Interest bearing
168,312
206,134
48,196
3,148
Total Liabilities Assumed
The fair value of the assets acquired includes loans with a fair value of $257.2 million. The gross principal and contractual interest due under the contracts is $359.2 million, of which $4.7 million is expected to be uncollectible. The loans have a weighted average life of 70 months.
The fair value of building and land included in premises and equipment was written down by $1.2 million and will be amortized based on the remaining life of each building. The combined average remaining life is 16.75 years.
The fair value for certificates of deposit incorporates a valuation amount of $0.5 million which will be amortized over 1.5 years. The fair value of Federal Home Loan Bank (FHLB) advances includes a valuation amount of $1.3 million which will be amortized over 2.3 years.
The Company acquired loans in the acquisition that had evidence of deterioration of credit quality since origination and it was probable, at acquisition, that all contractually required payments would not be collected.
Loans purchased with evidence of credit deterioration since origination and for which it is probable that all contractually required payments will not be collected are considered to be credit impaired. Evidence of credit quality deterioration as of the purchase date may include information such as past-due and nonaccrual status, borrower credit scores and recent loan to value percentages. Purchased credit-impaired loans are accounted for under the accounting guidance for loans and debt securities acquired with deteriorated credit quality (ASC 310-30) and initially measured at fair value, which includes estimated future credit losses expected to be incurred over the life of the loan. Accordingly, an allowance for credit losses related to these loans is not carried over and recorded at the acquisition date. Management estimated the cash flows expected to be collected at acquisition using our internal risk models, which incorporate the estimate of current key assumptions, such as default rates, severity and prepayment speeds.
11
The carrying amount of those loans is included in loans, net on the balance sheet at September 30, 2019. The amounts of loans at September 30, 2019 are as follows:
2019
Commercial
4,094
Consumer RE
231
Consumer
71
Carrying amount, net of fair value adjustment of $2,118
2,278
110
55
Carrying amount, net of fair value adjustment of $63
102
Loans acquired during 2019 for which it was probable at acquisition that all contractually required payments would not be collected are as follows:
Contractually required payments receivable at acquisition
4,215
261
94
Total required payments receivable
4,570
Cash flows expected to be collected at acquisition
2,788
Basis in acquired loans at acquisition
4,396
During the second quarter, two commercial purchased credit-impaired loans were paid off in full after the customer was able to secure financing at another financial institution. The associated credit loss of $1.985 million has been included in loan interest income in the Company’s consolidated statement of income for the nine months ended September 30, 2019. The balance of the fair value adjustment for loans acquired and accounted for under this guidance (ASC 310-30) was $63 thousand at September 30, 2019 and $2.118 million on January 1, 2019, respectively.
Changes in accretable yield, or income expected to be collected, are as follows:
Beginning Balance
2,329
2,544
Additions
Accretion
(112
(2,316
Reclassification from nonaccretable difference
34
2,019
Disposals
(6
Ending Balance
2,245
The results of operations of Bank of Geneva have been included in the Company’s consolidated financial statements since the acquisition date of January 1, 2019. The following schedule includes pro-forma results for the three and nine months ended September 30, 2019 and 2018 as if the Bank of Geneva acquisitions had occurred as of the beginning of the comparable prior reporting period.
12
Summary of Operations
13,198
40,916
77
474
Net Interest Income After Provision for Loan Losses
13,121
40,442
2,858
8,585
10,585
9,810
30,562
28,529
5,229
6,169
18,076
20,498
935
946
3,686
4,294
5,223
14,696
16,812
0.47
1.32
1.51
The pro-forma information includes adjustments for interest income on loans, amortization of intangibles arising from the transaction, interest expense on deposits acquired, premises expense for the branches acquired and the related income tax effects. The pro-forma information for the quarter ended September 30, 2019 includes approximately $5.5 million, net of tax, of operating revenue from Bank of Geneva since acquisition.
The pro-forma financial information is presented for informational purposes only and is not indicative of the results of operations that actually would have been achieved had the acquisition been consummated as of that time, nor is it intended to be a projection of future results.
The Company purchased an office on December 13, 2013 in Custar, Ohio. Core deposit intangible assets of $1.17 million were recognized and are being amortized over its remaining economic useful life of the deposits of 7 years on a straight line basis.
As mentioned previously, the acquisition of Bank of Geneva resulted in the recognition of $3.9 million in core deposit intangible assets which are being amortized over its remaining life of 7 years on a straight line basis.
The amortization expense for the nine months ended September 30, 2018 was $126 thousand. Of the $727 thousand to be expensed in 2019, $546 thousand has been expensed for the nine months ended September 30, 2019. Future amortization of core deposit intangible assets is as follows:
Custar
Geneva
167
560
727
2020
161
721
2021
2022
2023
2024
2025
328
3,920
4,248
NOTE 3 SECURITIES
Mortgage-backed securities, as shown in the following tables, are all government sponsored enterprises. The amortized cost and fair value of securities, with gross unrealized gains and losses at September 30, 2019 and December 31, 2018, follows:
Amortized
Gross Unrealized
Fair
Cost
Gains
Losses
Value
Available-for-Sale:
U.S. Treasury
14,029
(30
14,009
U.S. Government agencies
79,130
948
(35
80,043
Mortgage-backed securities
57,180
446
57,461
State and local governments
38,265
697
38,952
Total available-for-sale securities
188,604
2,101
(240
23,078
(254
22,830
71,235
(1,910
69,327
37,342
62
(1,142
36,262
40,608
225
(805
40,028
172,263
295
(4,111
Investment securities will at times depreciate to an unrealized loss position. The Company utilizes the following criteria to assess whether impairment is other than temporary. No one item by itself will necessarily signal that a security should be recognized as an other than temporary impairment.
1.
The fair value of the security has significantly declined from book value.
2.
A downgrade has occurred that lowered the credit rating to below investment grade (below Baa3 by Moody and BBB – by Standard and Poors.)
3.
Dividends have been reduced or eliminated or scheduled interest payments have not been made.
4.
The underwater security has longer than 10 years to maturity and the loss position had existed for more than 3 years.
5.
Management does not possess both the intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.
If the impairment is judged to be other than temporary, the cost basis of the individual security shall be written down to fair value, thereby establishing a new cost basis. The new cost basis shall not be changed for subsequent recoveries in fair value. The amount of the write down shall be included in current earnings as a realized loss. The recovery in fair value, if any, shall be recognized in earnings when the security is sold. The table below is presented by category of security and length of time in a continuous loss position. The Company currently does not hold any securities with other than temporary impairment.
14
NOTE 3 SECURITIES (Continued)
Information pertaining to securities with gross unrealized losses at September 30, 2019 and December 31, 2018, aggregated by investment category and length of time that individual securities have been in a continuous loss position follows:
Less Than Twelve Months
Twelve Months & Over
12,015
13,720
(48
(117
16,811
24,910
(9
2,425
1,100
3,525
(57
10,524
(183
43,646
54,170
20,861
64,727
(4
(1,138
30,347
31,044
(22
3,254
(783
29,413
32,667
3,951
(4,085
145,348
149,299
Unrealized losses on securities have not been recognized into income because the issuers’ bonds are of high credit quality, values have only been impacted by rate changes, and the Company has the intent and ability to hold the securities for the foreseeable future. Additionally, the decline in value is primarily due to changes in interest rates since the securities were purchased. The fair value is expected to recover as the bonds approach the maturity date.
Below are the gross realized gains and losses for the three and nine months ended September 30, 2019 and September 30, 2018.
Three Months
Nine Months
2018
Gross realized gains
51
16
Gross realized losses
(41
(42
Net realized losses
Tax expense related to net realized losses
(5
The net realized losses on sales and related tax expense is a reclassification out of accumulated other comprehensive income (loss). The net realized loss is included in net loss on sale of available-for-sale securities and the related tax expense is included in income taxes in the condensed consolidated statements of income and comprehensive income.
15
The amortized cost and fair value of debt securities at September 30, 2019, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Fair Value
One year or less
30,708
30,702
After one year through five years
52,474
52,597
After five years through ten years
46,971
48,433
After ten years
1,271
1,272
131,424
133,004
Investments with a carrying value of $89.2 million and $81.8 million at September 30, 2019 and December 31, 2018, respectively, were pledged to secure public deposits and securities sold under repurchase agreements.
Other securities include Federal Home Loan Bank of Cincinnati and Indianapolis stock as of September 30, 2019. As of December 31, 2018, other securities only includes Federal Home Loan Bank of Cincinnati stock.
NOTE 4 LOANS
Loan balances as of September 30, 2019 and December 31, 2018:
Loans:
Consumer Real Estate
159,074
80,766
Agricultural Real Estate
200,791
68,609
Agricultural
110,270
108,495
Commercial Real Estate
502,137
419,784
Commercial and Industrial
130,150
121,793
49,552
41,953
8,167
5,889
1,160,141
847,289
Less: Net deferred loan fees and costs
(1,445
(915
1,158,696
846,374
Less: Allowance for loan losses
(6,759
(6,775
Loans - Net
Other loans primarily fund public improvement in the Bank’s service area.
The distribution of fixed rate loans and variable rate loans by major loan category is as follows as of September 30, 2019:
Fixed
Variable
Rate
71,645
87,429
94,620
106,171
70,049
40,221
323,791
178,346
76,229
53,921
45,069
4,483
8,070
97
As of September 30, 2019 and December 31, 2018 one to four family residential mortgage loans amounting to $43.1 million and $14.9 million, respectively, have been pledged as security for future loans and existing loans the Bank has received from the Federal Home Loan Bank.
Unless listed separately, Other loans are included in the Commercial and Industrial category for the remainder of the tables in this Note 4.
NOTE 4 LOANS (Continued)
The following table represents the contractual aging of the recorded investment (in thousands) in past due loans by portfolio classification of loans as of September 30, 2019 and December 31, 2018, net of deferred loan fees and costs:
30-59 Days Past Due
60-89 Days Past Due
Greater Than 90 Days
Total Past Due
Current
Total Financing Receivables
Recorded Investment > 90 Days and Accruing
388
157,585
158,458
536
200,089
200,625
239
253
502
109,903
110,405
501,095
156
294
450
137,945
138,395
117
18
135
49,583
49,718
1,436
373
687
2,496
1,156,200
Recorded Investment >
90 Days and
Accruing
342
24
254
620
79,612
80,232
68,588
108,616
419,131
127,752
85
41,938
42,055
427
48
262
737
845,637
The following table presents the recorded investment in nonaccrual loans by class of loans as of September 30, 2019 and December 31, 2018:
September 30,
December 31,
904
462
1,830
Commercial & Industrial
456
72
3,275
542
Following are the characteristics and underwriting criteria for each major type of loan the Bank offers:
Consumer Real Estate: Purchase, refinance, or equity financing of one to four family owner occupied dwelling. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.
Agricultural Real Estate: Purchase of farm real estate or for permanent improvements to the farm real estate. Cash flow from the farm operation is the repayment source and is therefore subject to the financial success of the farm operation.
Agricultural: Loans for the production and housing of crops, fruits, vegetables, and livestock or to fund the purchase or re-finance of capital assets such as machinery and equipment and livestock. The production of crops and livestock is especially vulnerable to commodity prices and weather. The vulnerability to commodity prices is offset by the farmer’s ability to hedge their position by the use of future contracts. The risk related to weather is often mitigated by requiring crop insurance.
Commercial Real Estate: Construction, purchase, and refinance of business purpose real estate. Risks include potential construction delays and overruns, vacancies, collateral value subject to market value fluctuations, interest rate, market demands, borrower’s ability to repay in orderly fashion, and others. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer’s ability to repay in a changing rate environment before granting loan approval.
Commercial and Industrial: Loans to proprietorships, partnerships, or corporations to provide temporary working capital and seasonal loans as well as long term loans for capital asset acquisition. Risks include adequacy of cash flow, reasonableness of projections, financial leverage, economic trends, management ability and estimated capital expenditures during the fiscal year. The Bank does employ stress testing on higher balance loans to mitigate risk by ensuring the customer's ability to repay in a changing rate environment before granting loan approval.
Other: Primarily funds public improvements in the Bank’s service area. Repayment ability is based on the continuance of the taxation revenue as the source of repayment.
Consumer: Funding for individual and family purposes. Success in repayment is subject to borrower’s income, debt level, character in fulfilling payment obligations, employment, and others.
The Bank uses a nine tier risk rating system to grade its loans. The grade of a loan may change during the life of the loan.
The risk ratings are described as follows.
Zero (0) Unclassified. Any loan which has not been assigned a classification.
One (1) Excellent. Credit to premier customers having the highest credit rating based on an extremely strong financial condition, which compares favorably with industry standards (upper quartile of Risk Management Association ratios). Financial statements indicate a sound earnings and financial ratio trend for several years with satisfactory profit margins and excellent liquidity exhibited. Prime credits may also be borrowers with loans fully secured by highly liquid collateral such as traded stocks, bonds, certificates of deposit, savings account, etc. No credit or collateral exceptions exist and the loan adheres to the Bank's loan policy in every respect. Financing alternatives would be readily available and would qualify for unsecured credit. This grade is summarized by high liquidity, minimum risk, strong ratios, and low handling costs.
19
Two (2) Good. Desirable loans of somewhat less stature than Grade 1, but with strong financial statements. Loan supported by financial statements containing strong balance sheets, generally with a leverage position less than 1.50, and a history of profitability. Probability of serious financial deterioration is unlikely. Possessing a sound repayment source (and a secondary source), which would allow repayment in a reasonable period of time. Individual loans backed by liquid personal assets, established history and unquestionable character.
Three (3) Satisfactory. Satisfactory loans of average or slightly above average risk – having some deficiency or vulnerability to changing economic conditions, but still fully collectible. Projects should normally demonstrate acceptable debt service coverage. Generally, customers should have a leverage position less than 2.00. May be some weakness but with offsetting features of other support readily available. Loans that are meeting the terms of repayment.
Loans may be graded 3 when there is no recent information on which to base a current risk evaluation and the following conditions apply:
At inception, the loan was properly underwritten and did not possess an unwarranted level of credit risk:
a.
At inception, the loan was secured with collateral possessing a loan-to-value adequate to protect the Bank from loss;
b.
The loan exhibited two or more years of satisfactory repayment with a reasonable reduction of the principal balance;
c.
During the period that the loan has been outstanding, there has been no evidence of any credit weakness. Some examples of weakness include slow payment, lack of cooperation by the borrower, breach of loan covenants, or the business is in an industry which is known to be experiencing problems. If any of these credit weaknesses are observed, a lower risk grade is warranted.
Four (4) Satisfactory / Monitored. A “4” (Satisfactory/Monitored) risk grade may be established for a loan considered satisfactory but which is of average credit risk due to financial weakness or uncertainty. The loans warrant a higher than average level of monitoring to ensure that weaknesses do not advance. The level of risk in Satisfactory/Monitored classification is considered acceptable and within normal underwriting guidelines so long as the loan is given management supervision.
6.
Five (5) Special Mention. Loans that possess some credit deficiency or potential weakness which deserve close attention but do not yet warrant substandard classification. Such loans pose unwarranted financial risk that if not corrected could weaken the loan and increase risk in the future. The key distinctions of a 5 (Special Mention) classification are that (1) it is indicative of an unwarranted level of risk, and (2) weaknesses are considered “potential” versus “defined” impairments to the primary source of loan repayment and collateral.
7.
Six (6) Substandard. One or more of the following characteristics may be exhibited in loans classified substandard:
Loans which possess a defined credit weakness and the likelihood that a loan will be paid from the primary source and are uncertain. Financial deterioration is underway and very close attention is warranted to ensure that the loan is collected without loss.
Loans are inadequately protected by the current net worth and paying capacity of the borrower.
The primary source of repayment is weakened and the Bank is forced to rely on a secondary source of repayment such as collateral liquidation or guarantees.
d.
Loans are characterized by the distinct possibility that the Bank will sustain some loss if deficiencies are not corrected.
e.
Unusual courses of action are needed to maintain a high probability of repayment.
f.
The borrower is not generating enough cash flow to repay loan principal but continues to make interest payments.
g.
The lender is forced into a subordinate position or unsecured collateral position due to flaws in documentation.
h.
Loans have been restructured so that payment schedules, terms and collateral represent concessions to the borrower when compared to the normal loan terms.
i.
The lender is seriously contemplating foreclosure or legal action due to the apparent deterioration in the loan.
j.
There is significant deterioration in the market conditions and the borrower is highly vulnerable to these conditions.
8.
Seven (7) Doubtful. One or more of the following characteristics may be exhibited in loans classified Doubtful:
Loans have all of the weaknesses of those classified as Substandard. Additionally, these weaknesses make collection or liquidation in full based on existing conditions improbable.
The primary source of repayment is gone, and there is considerable doubt as to the quality of the secondary source of repayment.
The possibility of loss is high, but because of certain important pending factors which may strengthen the loan, loss classification is deferred until its exact status is known. A Doubtful classification is established deferring the realization of the loss.
9.
Eight (8) Loss. Loans are considered uncollectable and of such little value that continuing to carry them as assets on the institution’s financial statements is not feasible. Loans will be classified Loss when it is neither practical nor desirable to defer writing off or reserving all or a portion of a basically worthless asset, even though partial recovery may be possible at some time in the future.
21
The following table represents the risk category of loans by portfolio class, net of deferred fees and costs, based on the most recent analysis performed as of September 30, 2019 and December 31, 2018:
Real Estate
and Industrial
1-2
16,072
6,211
6,036
4,472
35,757
36,178
87,360
18,069
2,437
115,160
60,747
399,320
98,960
5,730
14,232
2,664
3,845
4,707
19,404
4,605
4,534
3,125
895
130,228
4,442
5,753
4,698
3,199
14,118
38,852
64,341
16,284
3,135
49,596
63,380
346,072
100,644
2,754
422
631
2,171
308
1,849
886
121,863
For consumer residential real estate, and other, the Company also evaluates credit quality based on the aging status of the loan, as was previously stated, and by payment activity. The following tables present the recorded investment in those classes based on payment activity and assigned risk grading as of September 30, 2019 and December 31, 2018.
Grade
Pass
155,346
79,121
Special Mention (5)
227
232
Substandard (6)
2,885
879
Doubtful (7)
Consumer - Credit
Consumer - Other
Performing
3,867
3,909
45,752
38,073
Nonperforming
99
54
3,928
45,851
38,127
Information about impaired loans as of September 30, 2019, December 31, 2018 and September 30, 2018 are as follows:
Impaired loans without a valuation allowance
1,914
1,808
1,841
Impaired loans with a valuation allowance
1,314
246
970
Total impaired loans
3,228
2,054
2,811
Valuation allowance related to impaired loans
31
148
Total non-accrual loans
483
Total loans past-due ninety days or more and
still accruing
Quarter ended average investment in impaired
loans
3,141
2,533
2,158
Year to date average investment in impaired
2,492
1,958
There were $5 thousand additional funds available to be advanced in connection with impaired loans.
The Bank had approximately $1.1 million of its impaired loans classified as troubled debt restructured (TDR) as of September 30, 2019, $178 thousand as of December 31, 2018 and $207 thousand as of September 30, 2018. During the year to date 2019, there were 5 new loans considered TDR. There were no new loans considered TDR year to date 2018.
23
The following table represents three and nine months ended September 30, 2019:
Pre-
Post-
Number of
Modification
Contracts
Outstanding
(in thousands)
Modified in the
Recorded
Troubled Debt Restructurings
Last Three Months
Investment
Last Nine Months
74
Commercial and
Industrial
812
For the three and nine month period ended September 30, 2019 and 2018, there were no TDRs that subsequently defaulted after modification.
For the three and nine month period ended September 30, 2019, there were no impaired loans classified as TDR paid off.
For the majority of the Bank’s impaired loans, the Bank will apply the fair value of collateral or use a measurement incorporating the present value of expected future cash flows discounted at the loan’s effective rate of interest. To determine fair value of collateral, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained. Until such time that updated appraisals are received, the Bank may discount the collateral value used.
The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off, whether a partial or full loan balance. A charge-off in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon notification of bankruptcy, unsecured debt is charged off. Additional charge-off may be realized as further unsecured positions are recognized.
The following tables present loans individually evaluated for impairment by class of loans for three months ended September 30, 2019 and September 30, 2018.
QTD
Three Months Ended September 30, 2019
Unpaid
Average
Income
Principal
Related
Recognized
Balance
Allowance
Cash Basis
With no related allowance recorded:
626
628
406
368
304
210
With a specific allowance recorded:
128
172
1,188
165
1,081
Totals:
752
754
800
1,398
1,300
25
Three Months Ended September 30, 2018
589
645
197
1,056
504
174
796
122
585
763
872
1,852
1,089
The following tables present loans individually evaluated for impairment by class of loans for nine months ended September 30, 2019 and September 30, 2018.
YTD
Nine Months Ended September 30, 2019
625
123
217
220
451
37
147
1,148
46
27
Nine Months Ended September 30, 2018
554
199
238
153
186
413
707
385
651
As of September 30, 2019, the Company had $187 thousand of foreclosed residential real estate property obtained by physical possession and $379 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings are in process according to local jurisdictions. As of September 30, 2018, the Company had $68 foreclosed residential real estate property obtained by physical possession and $174 thousand of consumer mortgage loans secured by residential real estate properties for which foreclosure proceedings were in process according to local jurisdictions.
28
The Allowance for Loan and Lease Losses (ALLL) has a direct impact on the provision expense. An increase in the ALLL is funded through recoveries and provision expense. The following tables summarize the activities in the allowance for credit losses.
Twelve Months Ended
Allowance for Loan & Lease Losses
Balance at beginning of year
6,775
6,868
324
Loans charged off
(554
(580
Recoveries
163
6,759
Allowance for Unfunded Loan Commitments &
Letters of Credit
430
274
Total Allowance for Credit Losses
7,189
7,049
The Company segregates its ALLL into two reserves: The ALLL and the Allowance for Unfunded Loan Commitments and Letters of Credit (AULC). When combined, these reserves constitute the total Allowance for Credit Losses (ACL).
The AULC is reported within other liabilities on the balance sheet while the ALLL is netted within the loans, net asset line. The ACL presented above represents the full amount of reserves available to absorb possible credit losses.
29
The following table breaks down the activity within ACL for each loan portfolio classification and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs.
Additional analysis, presented in thousands, related to the allowance for credit losses for three months ended September 30, 2019 and September 30, 2018 in addition to the ending balances as of December 31, 2018 is as follows:
Unfunded
Loan
Commitment
& Letters of
Credit
Unallocated
ALLOWANCE FOR CREDIT LOSSES:
Beginning balance
340
756
3,320
1,461
526
370
7,053
Charge Offs
(39
(55
(103
(219
32
Provision (Credit)
(17
131
90
Other Non-interest expense related to
unfunded
352
733
3,305
1,550
545
Ending balance: individually evaluated
for impairment
Ending balance: collectively evaluated
252
1,385
7,002
Ending balance: loans acquired with
deteriorated credit quality
FINANCING RECEIVABLES:
Ending balance
157,659
200,219
110,037
500,791
136,997
1,155,421
30
250
768
3,217
1,305
484
Ending balance: individually evaluated for
impairment
Ending balance: collectively evaluated for
221
7,018
Ending balance: loans acquired with deteriorated
credit quality
757
1,103
79,359
418,937
126,649
844,204
116
251
255
751
3,260
1,420
315
393
7,104
(29
(94
(123
42
(3
(25
88
235
3,272
471
333
384
7,088
209
1,276
6,940
82,629
68,524
103,760
416,632
125,612
41,541
838,698
81,748
416,436
123,760
835,769
118
Additional analysis, presented in thousands, related to the allowance for credit losses for nine months ended September 30, 2019 and September 30, 2018 is as follows:
(95
(382
279
346
(504
33
343
244
667
1,546
441
7,095
(63
(100
(450
79
70
(56
223
106
NOTE 5 EARNINGS PER SHARE
Basic earnings per share are calculated using the two-class method. The two-class method is an earnings allocation formula under which earnings per share is calculated from common stock and participating securities according to dividends declared and participation rights in undistributed earnings. Under this method, all earnings distributed and undistributed, are allocated to participating securities and common shares based on their respective rights to receive dividends. Unvested share-based payment awards that contain non-forfeitable rights to dividends are considered participating securities (i.e. unvested restricted stock), not subject to performance based measures. Basic earnings per share is calculated by dividing net income available to common shareholders by the weighted average number of common shares outstanding. Application of the two-class method for participating securities results a more dilutive basic earnings per share as the participating securities are allocated the same amount of income as if they are outstanding for purposes of basic earnings per share. There is no additional potential dilution in calculating diluted earnings per share, therefore basic and diluted earnings per share are the same amounts. Other than the restricted stock plan, the Company has no other stock based compensation plans.
Earnings per share
Less: distributed earnings allocated to participating
(14
(37
(38
Less: undistributed earnings allocated to participating
(18
(80
Net earnings available to common shareholders
4,243
3,836
13,579
11,638
Weighted average common shares outstanding including
participating securities
11,121,426
9,274,507
11,105,993
9,268,819
Less: average unvested restricted shares
(79,335
(93,242
(81,569
(92,683
Weighted average common shares outstanding
11,042,091
9,181,265
11,024,424
9,176,136
Basic earnings and diluted per share
35
NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS
Fair values of financial instruments are management's estimate of the values at which the instruments could be exchanged in a transaction between willing parties. These estimates are subjective and may vary significantly from amounts that would be realized in actual transactions. In addition, other significant assets are not considered financial assets including deferred tax assets, premises, equipment and intangibles. Further, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on the fair value estimates and have not been considered in any of the estimates.
The following assumptions and methods were used in estimating the fair value for financial instruments:
Cash and Cash Equivalents
The carrying amounts reported in the balance sheet for cash, cash equivalents and federal funds sold approximate their fair values. Also included in this line item are the carrying amounts of interest-bearing deposits maturing within ninety days which approximate their fair values. Fair values of other interest-bearing deposits are estimated using discounted cash flow analyses based on current rates for similar types of deposits.
Interest Bearing Time Deposits
Fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Securities – Available-for-sale
Fair values for securities, excluding Federal Home Loan Bank are based on quoted market price, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
Other Securities
The carrying value of Federal Home Loan Bank stock of Cincinnati and Indianapolis, approximates fair value based on the redemption provisions of the respective Federal Home Loan Bank.
Loans Held for Sale
The carrying amount approximates fair value due to insignificant amount of time between origination and date of sale.
The fair values of the loans are estimated using a credit mark adjustment along with discounted cash flow analysis, using interest rates currently being offered for loans with similar terms to borrowers with similar credit quality. The credit mark adjustment was estimated using merger and acquisition analysis of nationwide bank and thrift deals and/or the Bank’s most recent acquisition experience.
The fair values disclosed for deposits with no defined maturities are equal to their carrying amounts, which represent the amount payable on demand. The carrying amounts for variable-rate, fixed term money market accounts and certificates of deposit approximate their fair value at the reporting date. Fair value for fixed-rate certificates of deposit are estimated using a discounted cash flow analysis that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits.
Federal Funds Purchased and Securities Sold Under Agreements to Repurchase
The carrying value of federal funds purchased and securities sold under agreements to repurchase approximates fair values.
FHLB Advances
Fair values or FHLB advances are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types or borrowing arrangements.
36
NOTE 6 FAIR VALUE OF FINANCIAL INSTRUMENTS (Continued)
Accrued Interest Receivable and Payable
The carrying amounts of accrued interest approximate their fair values.
Off Balance Sheet Financial Instruments
Fair values for off-balance sheet, credit related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter-parties' credit standing.
The estimated fair values, and related carrying or notional amounts, for on and off-balance sheet financial instruments as of September 30, 2019 and December 31, 2018 are reflected below.
Carrying
Amount
Level 1
Level 2
Level 3
Financial Assets:
174,947
1,509
Other securities
1,129,954
Interest receivable
7,830
Financial Liabilities:
Interest bearing deposits
741,313
741,360
Non-interest bearing deposits
Time deposits
275,658
Total Deposits
1,278,707
1,016,988
agreement to repurchase
Federal Home Loan Bank advances
24,672
Interest payable
739
3,954
36,935
130,085
1,427
823,914
4,542
525,955
187,545
928,922
713,500
3,181
418
Fair Value Measurements
In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities in active markets that the Company has the ability to access.
Available-for-sale securities, when quoted prices are available in an active market, securities are valued using the quoted price and are classified as Level 1.
Fair values determined by Level 2 inputs use other inputs that are observable, either directly or indirectly. These Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and other inputs such as interest rates and yield curves that are observable at commonly quoted intervals.
Available-for-sale securities classified as Level 2 are valued using the prices obtained from an independent pricing service. The prices are not adjusted. Securities of obligations of state and political subdivisions are valued using a type of matrix, or grid, pricing in which securities are benchmarked against the treasury rate based on credit rating. Substantially all assumptions used by the independent pricing service are observable in the marketplace, can be derived from observable data, or are supported by observable levels at which transactions are executed in the marketplace.
Level 3 inputs are unobservable inputs, including inputs that are available in situations where there is little, if any, market activity for the related asset or liability. The Bank holds some local municipals that the Bank evaluates based on the credit strength of the underlying project. The fair value is determined by valuing similar credit payment streams at similar rates.
In instances where inputs used to measure fair value fall into different levels in the above fair value hierarchy, fair value measurements in their entirety are categorized based on the lowest level input that is significant to the valuation. The Company's assessment of the significance of particular inputs to these fair value measurements requires judgment and considers factors specific to each asset.
The following summarizes financial assets measured at fair value on a recurring basis as of September 30, 2019 and December 31, 2018, segregated by level or the valuation inputs within the fair value hierarchy utilized to measure fair value:
Assets and Liabilities Measured at Fair Value on a Recurring Basis (In Thousands)
Quoted Prices in
Active Markets
for Identical
Assets (Level 1)
Significant
Observable
Inputs
(Level 2)
(Level 3)
Assets - (Securities Available-for-Sale)
37,443
Total Securities Available-for-Sale
14,105
55,222
38,601
The following tables represent the changes in the Level 3 fair-value category of which unobservable inputs are relied upon as of the three and nine month periods ended September 30, 2019 and September 30, 2018.
Fair Value Measurements Using Significant
Unobservable Inputs (Level 3)
State and Local
Governments
Tax-Exempt
Taxable
Balance at July 1, 2019
1,505
Change in Market Value
Payments & Maturities
Balance at September 30, 2019
39
Balance at January 1, 2019
82
Balance at July 1, 2018
1,423
Balance at September 30, 2018
1,393
Balance at January 1, 2018
1,428
Most of the Company's available-for-sale securities, including any bonds issued by local municipalities, have CUSIP numbers or have similar characteristics of those in the municipal markets, making them marketable and comparable as Level 2.
The Company also has assets that, under certain conditions, are subject to measurement at fair value on a non-recurring basis. At September 30, 2019 and December 31, 2018, such assets consist primarily of collateral dependent impaired loans. Collateral dependent impaired loans categorized as Level 3 assets consist of non-homogeneous loans that are considered impaired. The Company estimates the fair value of the loans based on the present value of expected future cash flows using management's best estimate of key assumptions. These assumptions include future payment ability, timing of payment streams, and estimated realizable values of available collateral (typically based on outside appraisals.)
40
At September 30, 2019 and December 31, 2018, fair value of collateral dependent impaired loans categorized as Level 3 was $106 and $215 thousand, respectively. The specific allocation for impaired loans was $22 and $31 thousand as of September 30, 2019 and December 31, 2018, respectively, which are accounted for in the allowance for loan losses (see Note 4).
Other real estate is reported at either the lower of the fair value of the real estate minus the estimated costs to sell the asset or the cost of the asset. The determination of fair value of the real estate relies primarily on appraisals from third parties. If the fair value of the real estate, minus the estimated costs to sell the asset, is less than the asset's cost, the deficiency is recognized as a valuation allowance against the asset through a charge to expense. The valuation allowance is therefore increased or decreased, through charges or credits to expense, for changes in the asset's fair value or estimated selling costs.
The following table presents quantitative information about unobservable inputs used in recurring and nonrecurring Level 3 fair value measurements:
Range
Fair Value at
(Weighted
Valuation Technique
Unobservable Inputs
Average)
State and local government
Discounted Cash Flow
Credit strength of underlying project or
entity / Discount rate
0-5%
(2.41%)
Collateral dependent
impaired loans
Collateral based
measurements
Discount to reflect current market
conditions and ultimate collectability
0-50%
(17.19%)
Other real estate owned -
commercial
Appraisals
Discount to reflect current
market
0-20%
(23.31% )
(3.51%)
215
(12.38%)
— %
( — )
41
The following table presents impaired loans and other real estate owned as recorded at fair value on September 30, 2019 and December 31, 2018:
Assets Measured at Fair Value on a Nonrecurring Basis at September 30, 2019
Balance at
Quoted Prices
in Active
Markets for
Identical
Observable Inputs
Other real estate
owned - commercial
Assets Measured at Fair Value on a Nonrecurring Basis at December 31, 2018
NOTE 7 FEDERAL FUNDS PURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
The Company had no Federal Funds purchased as of September 30, 2019 and $6.5 million as of December 31, 2018, respectively. During the same time periods, the company also had $30.1 million and $25.7 million in securities sold under agreement to repurchase.
Remaining Contractual Maturity of the Agreements (In Thousands)
Overnight & Continuous
Up to 30 days
30-90 days
Greater Than
90 days
Federal funds purchased
Repurchase agreements
US Treasury & agency securities
1,698
28,358
6,486
24,889
25,695
7,292
43
NOTE 8 RECENT ACCOUNTING PRONOUNCEMENTS
In February 2016, the FASB issued ASU No. 2016-02 “Leases (Topic 842).” ASU 2016-02 establishes a right of use model that requires a lessee to record a right of use asset and a lease liability for all leases with terms longer than 12 months. Leases will be classified as either finance or operating, with classification affecting the pattern of expense recognition in the income statement. For lessors, the guidance modifies the classification criteria and the accounting for sales-type and direct financing leases. A lease will be treated as sale if it transfers all of the risks and rewards, as well as control of the underlying asset, to the lessee. If risks and rewards are conveyed without the transfer of control, the lease is treated as a financing. If the lessor doesn’t convey risks and rewards or control, an operating lease results. The amendments are effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years for public business entities. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements, with certain practical expedients available. Early adoption is permitted. The Company has adopted ASU 2016-02 on January 1, 2019 and recorded a right of use asset and a corresponding liability in the amount of $491.7 thousand. This did not have a significant impact on the company’s financial statements.
In June 2016, FASB issued ASU No. 2016-13 “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.” The ASU requires the measurement of all expected credit losses for financial assets held at the reporting date based on historical experience, current conditions, and reasonable and supportable forecasts. Financial institutions and other organizations will now use forward-looking information to better inform their credit loss estimates. Many of the loss estimation techniques applied today will still be permitted, although the inputs to those techniques will change to reflect the full amount of expected credit losses. Organizations will continue to use judgment to determine which loss estimation method is appropriate for their circumstances. The ASU requires enhanced disclosures to help investors and other financial statement users better understand significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization’s portfolio. These disclosures include qualitative and quantitative requirements that provide additional information about the amounts recorded in the financial statements. In addition, the ASU amends the accounting for credit losses on available-for-sale debt securities and purchased financial assets with credit deterioration.
The ASU is effective for SEC filers for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2019 (i.e., January 1, 2020, for calendar year entities). FASB recently approved a delay in adoption for Smaller Reporting Companies. The Company has completed an analysis to determine they qualify as a Smaller Reporting Company. Adoption can be postponed until December 15, 2022 (i.e., January 1, 2023, for calendar year entities) . Early application will be permitted for all organizations for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. The Company has contracted with an external advisor and has formed a committee to determine the methodology to be used. Most importantly, the Company is gathering as much data as possible to enable review scenarios and determine which calculations will produce the most reliable results. The Company began working with the third party service provider to review parallel reports starting in June 2019. The Company will not adopt in calendar year 2020 and is currently evaluating when or if they would early adopt.
In January 2017, the FASB issued ASU No. 2017-04 “Intangibles – Goodwill and other (Topic 350) – Simplifying the Test for Goodwill Impairment.” These amendments eliminate Step 2 from the goodwill impairment test. The amendments also eliminate the requirements for any reporting unit with a zero or negative carrying amount to perform a qualitative assessment and, if it fails that qualitative test, to perform Step 2 of the goodwill impairment test. An entity still has the option to perform the qualitative assessment for a reporting unit to determine if the quantitative impairment test is necessary. The guidance is effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017. ASU 2017-04 should be adopted on a prospective basis. The Company does not expect ASU 2017-04 to have a material impact on its financial statements, as goodwill testing has been completed annually without any impairment concerns.
In August 2018, the FASB issued ASU No. 2018-13 “Fair Value Measurement (Topic 820) - Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement.” ASU 2018-13 modifies the disclosure requirements on fair value measurements in Topic 820. The amendments in this update remove disclosures that no longer are considered cost beneficial, modify/clarify the specific requirements of certain disclosures, and add disclosure requirements identified as relevant. ASU 2018-13 is effective for years beginning after December 15, 2019, with early adoption permitted. The Company is in the process of evaluating and does not expect ASU 2018-13 to have a material impact on its accounting disclosures.
44
ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Company continued second quarter’s “quarter of execution” to the “quarter on fire” for the third quarter of 2019. The first quarter of 2019 was impacted by a very labor-intensive process as we welcomed new employees, customers and shareholders into the F&M family. This followed our merger with Limberlost Bancshares, Inc. on January 1, 2019 and three weeks later the integration of the Bank of Geneva into The Farmers & Merchants State Bank’s core operating system. Financially, the merger is becoming accretive to earnings during 2019, with a larger legal lending limit enabling the expansion of existing customer’s borrowings, and a wider range of product and services now available to all customers. The second and third quarters have been the time to focus on these new opportunities.
A Chief People Officer was added in second quarter 2019 to assist with increasing the level of our Company’s talent. The Company has invested in our retail infrastructure and has been conducting extensive training. During the last two quarters, the Company has spent time developing a three year strategic plan. The vision statement was updated to be “Community Vested to Help People Realize Their Best Lives.” An outcome of the strategic planning process included the following five strategic initiatives that will help take the Company to the next level: customer acquisition and retention, talent optimization, actively pursue acquisition opportunities, improve operating efficiency and financial performance, and develop a comprehensive digital strategy for internal and external constituencies.
The third quarter growing conditions for late planted crops were favorable with the crop outlook better than originally anticipated given the late planting dates. The use of crop insurance and the receipt of government subsidies for many of our farms will result in an acceptable year. The large grain carryover and trade disruptions as a result of tariffs continue to weigh on commodity prices. Agri-businesses will likely feel the largest negative effect of non-planted acreage; although, it is believed most are financially sound and have the ability to withstand the potential negative financial impact. Recent land sales continue to be strong suggesting farmer optimism and an overall solid financial position. Results will continue to be monitored going into fourth quarter and 2020. The overall ag sector remains healthy.
The labor shortage is still impacting our commercial customers; whether it is slowing existing projects or expanding the use of technology. It remains one of the largest concerns for 2019. Performance is strong and competition is fierce. The strong performance is evidenced by the size of paydowns and payoffs that have occurred. Regional banks in our market area are busy with larger projects and the small to midsize business segment is where our community bank excels. Overall, the commercial division is optimistic on growth. Many loans which closed in the second quarter were funded in the third, replacing the accelerated paydowns and payoffs of the first half of the year. Two larger relationships which include construction may not be completely drawn until the fourth quarter. The commercial real estate market remains very active and competition is extending amortization and rate terms. Commercial and industrial markets remain healthy with competition thinly priced creating a high demand for the borrower’s non-credit business.
Nationally, the automotive demand has fallen below 17 million units for the first time since 2014. The Bank ran an automotive special during second quarter and has been able to maintain the portfolio balances in the retail market. The yield on the new loans being generated is also higher than what last year’s loans were, by about 50 basis points. The Bank has been busy contracting with automotive dealers in the newer markets to expand our opportunities. This should help to maintain the balances in the consumer market.
Home loan origination activity substantially improved in the third quarter and the division was on fire. One of the biggest impediments to continued improvement is the lack of available housing in our markets, specifically at the moderate level. The Bank is experiencing increased activity in purchases and home improvement. Fixed mortgage rates fell in third quarter resulting in an increase in refinance volume.
Yield on loans is high due to the payoff of two loans in the second quarter, the same relationship, that was a reversal of a fair value adjustment of almost $2 million that was established in the Limberlost acquisition. The payoff totaled approximately $3.8 million as the customer was able to secure financing elsewhere. This enabled the widening of the net interest margin which would have tightened otherwise from the increased cost of funds outpacing the asset yield improvement. Cost of deposits continues to put pressure on the margin.
Profitability from core operations is on track to match the expectations for 2019 with the acquisition factored in. As additional acquisition costs continue to lessen, the negative impact on ROA, and ROE should also lessen. F&M will continue to operate on the foundation of a strong community bank platform in the communities we serve and are a part of.
45
(Continued)
The focus remains on growth for 2019 along with the widening of our footprint from additional offices. Welcoming and developing our newest offices is also important and a priority. The Company is positioned for positive results in 2019 and remains well capitalized.
NATURE OF ACTIVITIES
Farmers & Merchants Bancorp, Inc. (the “Company”) is a financial holding company incorporated under the laws of Ohio in 1985. Our subsidiaries are The Farmers & Merchants State Bank (the “Bank”), a community bank operating in Northwest Ohio since 1897, and Farmers & Merchants Risk Management, Inc., a captive insurance company formed in December 2014 and located in Nevada. We report our financial condition and net income on a consolidated basis and we have only one segment.
Our executive offices are located at 307 North Defiance Street, Archbold, Ohio 43502, and our telephone number is (419) 446-2501. The Bank operates thirty full service banking offices throughout Northwest Ohio and Northeast Indiana.
On January 1, 2019, six offices of Bank of Geneva, located in the Indiana counties of Adams, Allen and Jay, were merged with and into The Farmers & Merchants State Bank. The Bank has continued its expansion strategy and the new offices are expected to provide new growth opportunities.
The Farmers & Merchants State Bank engages in general commercial banking and savings business including commercial, agricultural and residential mortgage, consumer and credit card lending activities. The largest segment of the lending business relates to commercial, both real estate and non-real estate. The type of commercial business ranges from small business to multi-million dollar companies. The loans are a reflection of business located within the Banks’ market area. Because the Bank's offices are located in Northwest Ohio and Northeast Indiana, a substantial amount of the loan portfolio is comprised of loans made to customers in the farming industry for such items as farm land, farm equipment, livestock and operating loans for seed, fertilizer, and feed. Other types of lending activities include loans for home improvements, and loans for the purchase of autos, trucks, recreational vehicles, motorcycles, and other consumer goods.
The Bank also provides checking account services, as well as savings and time deposit services such as certificates of deposits. In addition, Automated Teller Machines (ATMs) or Interactive Teller Machines (ITMs) are provided at most branch locations along with other independent locations in the market area. ITMs operate as an ATM with the addition of remote teller access to assist the user. The Bank has custodial services for Individual Retirement Accounts (IRAs) and Health Savings Accounts (HSAs). The Bank provides on-line banking access for consumer and business customers. For consumers, this includes bill-pay, on-line statement opportunities and mobile banking. For business customers, it provides the option of electronic transaction origination such as wire and Automated Clearing House (ACH) file transmittal. In addition, the Bank offers remote deposit capture or electronic deposit processing and merchant credit card services. Mobile banking was added in 2012 and has been widely accepted and used by consumers. Over the past couple of years, the Bank has updated its consumer offerings with “Secure” and “Pure” checking in 2014 and with KASASA Cash Back in 2015. During the second quarter 2017, new business checking products were announced and existing business accounts were converted to one of three new products, Business Essential, Edge or Elite. The new products provided customers with new options to bundle services and for the Bank to utilize the full relationship to determine pricing. This was the next step of implementation for the Bank’s “earn to free” strategic initiative. During second quarter 2019, “Smart 25” checking and Business Money Market savings products were launched. Upgrades to our digital products and services continue to occur in both retail and business lines.
The Bank has established underwriting policies and procedures which facilitate operating in a safe and sound manner in accordance with supervisory and regulatory guidance. Within this sphere of safety and soundness, the Bank's practice has been to not promote innovative, unproven credit products which may not be in the best interest of the Bank or its customers. The Bank does offer a hybrid mortgage loan. Hybrid loans are loans that start out as a fixed rate mortgage but after a set number of years automatically adjust to an adjustable rate mortgage. The Bank offers a three year fixed rate mortgage after which the interest rate will adjust annually. The majority of the Bank's adjustable rate mortgages are of this type. In order to offer longer term fixed rate mortgages, the Bank does participate in the Freddie Mac, Farmer Mac and Small Business Lending programs. The Bank also normally retains the servicing rights on these partially or 100% sold loans. In order for the customer to participate in these programs they must meet the requirements established by those agencies. In addition, the Bank does sell some of its longer term fixed rate agricultural mortgages into the secondary market with the aid of a broker.
The Bank does not have a program to fund sub-prime loans. Sub-prime loans are characterized as a lending program or strategy that targets borrowers who pose a significantly higher risk of default than traditional retail banking customers.
All loan requests are reviewed as to credit worthiness and are subject to the Bank's underwriting guidelines as to secured versus unsecured credit. Secured loans are in turn subject to loan to value (LTV) requirements based on collateral types as set forth in the Bank's Loan Policy. In addition, credit scores of those seeking consumer credit are reviewed and if they do not meet the Bank's Loan Policy guidelines an additional officer approval is required.
Consumer Loans:
•
Maximum loan to value (LTV) for cars, trucks and light trucks vary from 90% to 110% depending on whether direct or indirect.
Loans above 100% are generally the result of additional charges for extended warranties and/or insurance coverage for wage or death.
Boats, campers, motorcycles, RV's and Motor Coaches range from 80%-90% based on age of vehicle.
1st or 2nd mortgages on 1-4 family homes range from 75%-90% with "in-house" first real estate mortgages requiring private mortgage insurance on those exceeding 80% LTV.
Raw land LTV maximum ranges from 65%-75% depending on whether or not the property has been improved.
Commercial/Agriculture/Real Estate:
Maximum LTVs range from 70%-80% depending on type.
Accounts Receivable: Up to 80% LTV less retainages and greater than 90 days.
Maximum LTV on non-traditional loan up to 85%.
Inventory:
Agriculture:
Livestock and grain up to 80% LTV, crops (insured) up to 75% and Warehouse Receipts up to 87%.
Commercial:
Maximum LTV of 50% on raw and finished goods.
Floor plan:
o
New/used vehicles to 100% of wholesale.
New/Used recreational vehicles and manufactured homes to 80% of wholesale.
Equipment:
New not to exceed 80% of invoice, used NTE 50% of listed book or 75% of appraised value.
Restaurant equipment up to 35% of market value.
Heavy trucks, titled trailers up to NTE 75% LTV and aircraft up to 75% of appraised value.
F&M Investment Services, the brokerage department of the Bank, opened for business in April 1999. Securities are offered through Raymond James Financial Services, Inc.
In December of 2014, the Company became a financial holding company within the meaning of the Bank Holding Company Act of 1956 as amended (the “Act”), in order to provide the flexibility to take advantage of the expanded powers available to a financial holding company under the Act. Our subsidiary bank is in turn regulated and examined by the Ohio Division of Financial Institutions and the Federal Deposit Insurance Corporation. The activities of our bank subsidiary are also subject to other federal and state laws and regulations. The Company also formed a captive insurance company (the “captive”) in December 2014 which is located in Nevada and regulated by the State of Nevada Division of Insurance.
The Bank’s primary market includes communities located in the Ohio counties of Defiance, Fulton, Hancock, Henry, Lucas, Williams, Wood and in the Indiana counties of Adams, Allen, DeKalb, Jay and Steuben. In our banking activities, we compete directly with other commercial banks, credit unions, farm credit services, and savings and loan institutions in each of our operating localities. In a number of our locations, we compete against entities which are much larger than us. The primary factors in competing for loans and deposits are the rates charged as well as location and quality of the services provided.
At September 30, 2019, we had 355 full time equivalent employees. The employees are not represented by a collective bargaining unit. We provide our employees with a comprehensive benefit program, some of which are contributory. We consider our employee relations to be good.
REGULATORY DEVELOPMENTS
The Bank remains attentive to the current regulatory environment in light of the regulatory agencies’ risk-based approach to examinations. Regulatory changes and the complexity of new and amended rules have resulted in lack of clarity and uncertainties which could pose an increased risk of noncompliance. Various significant mortgage rules require monitoring by means of testing, validation of results, additional training, and further research or consultation to assist with ongoing compliance.
The Economic Growth Regulatory Relief and Consumer Protection Act (EGRRCPA) was signed into law in May 2018. EGRRCPA was intended to pave the way for banks to lend to creditworthy borrowers and better serve their communities. Rollback of some burdensome requirements resulting from the Dodd-Frank Wall Street Reform and Consumer Protection Act was welcomed by community banks. Regulatory relief has not been immediate, as guidance and new rulemaking remains to be completed to implement various provisions. Sections in the EGRRCPA address access to mortgage credit; consumer access to credit; protections for veterans, consumers, and homeowners; rules for certain bank holding companies, capital access; and protections for student borrowers. Implementation of the rules and guidance for the various provisions of the EGRRCPA will commence as rulemaking occurs.
The U.S. Department of the Treasury’s final rules on Customer Due Diligence (CDD) and Beneficial Ownership added a fifth core element to the original core elements necessary for an effective Bank Secrecy Act and Anti-Money Laundering compliance program. These rules were effective in May 2018. The CDD Final Rule is a significant step toward greater financial transparency. Prior to these new rules, the ability for individuals to hide financial activity through anonymous ownership of business entities was a weakness in the fight against financial crime. By gaining a more complete profile of entity customers, financial institutions can help further reduce the flow of illicit funds through the US banking system.
The Company has implemented Basel III capital rules which began to be phased in for the Company on January 1, 2015. These rules may impact the ability of some financial institutions to pay dividends, though the Company believes itself to be able to maintain its strong capital position and not be limited in that regard.
With regard to all regulatory matters, the Bank remains committed in making good faith efforts to comply with technical requirements of the laws, rules, regulations, and guidance from both federal and state agencies which govern its activities.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The Company's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, and the Company follows general practices within the financial services industry in which it operates. At times the application of these principles requires management to make assumptions, estimates and judgments that affect the amounts reported in the financial statements and accompanying notes.
These assumptions, estimates and judgments are based on information available as of the date of the financial statements. As this information changes, the financial statements could reflect different assumptions, estimates and judgments. Certain policies inherently have a greater reliance on assumptions, estimates and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Examples of critical assumptions, estimates and judgments are when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not required to be recorded at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability must be recorded contingent upon a future event. These policies, along with the disclosures presented in the notes to the condensed consolidated financial statements and in the management discussion and analysis of the financial condition and results of operations, provide information on how significant assets and liabilities are valued and how those values are determined for the financial statements. Based on the valuation techniques used and the sensitivity of financial statement amounts to assumptions, estimates, and judgments underlying those amounts, management has identified the determination of the ALLL, the valuation of its Mortgage Servicing Rights and the valuation of real estate acquired through or in lieu of; loan foreclosures (“OREO Property”) as the accounting areas that require the most subjective or complex judgments, and as such could be the most subject to revision as new information becomes available.
OREO Property held for sale and is initially recorded at fair value at the date of foreclosure. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of cost or fair value minus estimated costs to sell.
Costs of holding foreclosed real estate are charged to expense in the current period, except for significant property improvements, which are capitalized. Valuations are periodically performed by management and a write-down is recorded by a charge to non-interest expense if the carrying value exceeds the fair value minus estimated costs to sell.
The net income from operations of foreclosed real estate held for sale is reported either in noninterest income or noninterest expense depending upon whether the property is in a gain or loss position overall. At September 30, 2019 OREO property holdings were $351 thousand. OREO totaled $600 thousand and $717 thousand as of December 31, 2018 and September 30, 2018 respectively.
The ALLL and ACL represents management’s estimate of probable credit losses inherent in the Bank’s loan portfolio, unfunded loan commitments, and letters of credit at the report date. The ALLL methodology is regularly reviewed for its appropriateness and is approved annually by the Board of Directors. This written methodology is consistent with Generally Accepted Accounting Principles which provides for a consistently applied analysis.
The Bank’s methodology provides an estimate of the probable credit losses either by calculating a specific loss per credit or by applying a composite of historical factors over a relevant period of time with current internal and external factors which may affect credit collectability. Such factors which may influence estimated losses are the conditions of the local and national economy, local unemployment trends, and abilities of lending staff, valuation trends of fixed assets, and trends in credit delinquency, classified credits, and credit losses.
Inherent in most estimates is imprecision. The Bank’s ALLL may include a margin for imprecision with an unallocated portion. Bank regulatory agencies and external auditors periodically review the Bank’s methodology and adequacy of the ALLL. Any required changes in the ALLL or loan charge-offs by these agencies or auditors may have a material effect on the ALLL.
The Bank is also required to estimate the value of its mortgage servicing rights. The Bank’s mortgage servicing rights relating to fixed rate single-family mortgage loans that is has sold without recourse but services for others for a fee represent an asset on the Bank’s balance sheet. The valuation is completed by an independent third party.
The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced.
The Bank’s mortgage servicing rights relating to loans serviced for others represent an asset. This asset is initially capitalized and included in other assets on the Company's consolidated balance sheet. The mortgage servicing rights are then amortized against noninterest income in proportion to, and over the period of the estimated future net servicing income of the underlying mortgage servicing rights using the level yield method. The amortization thereof is recorded in non-interest expense. There are a number of factors, however, that can affect the ultimate value of the mortgage servicing rights to the Bank. The expected and actual rates of mortgage loan prepayments are the most significant factors driving the potential for the impairment of the value of mortgage servicing assets. Increases in mortgage loan prepayments reduce estimated future net servicing cash flows because the life of the underlying loan is reduced, meaning that the present value of the mortgage servicing rights is less than the carrying value of those rights on the Bank's balance sheet. Therefore, in an attempt to reflect an accurate expected value to the Bank of the mortgage servicing rights, the Bank receives a valuation of its mortgage servicing rights from an independent third party. The independent third party's valuation of the mortgage servicing rights is based on relevant characteristics of the Bank's loan servicing portfolio, such as loan terms, interest rates and recent national prepayment experience, as well as current national market interest rate levels, market forecasts and other economic conditions. For purposes of determining impairment, the mortgage servicing assets are stratified into like groups based on loan type, term, new versus seasoned and interest rate. Management, with the advice from its third party valuation firm, reviewed the assumptions related to prepayment speeds, discount rates, and capitalized mortgage servicing income on a quarterly basis. Changes are reflected in the following quarter's analysis related to the mortgage servicing asset. In addition, based upon the independent third party's valuation of the Bank's mortgage servicing rights, management then establishes a valuation allowance by each strata, if necessary, to quantify the likely impairment of the value of the mortgage servicing rights to the Bank. The estimates of prepayment speeds and discount rates are inherently uncertain, and different estimates could have a material impact on the Bank's net income and results of operations. The valuation allowance is evaluated and adjusted quarterly by management to reflect changes in the fair value of the underlying mortgage servicing rights based on market conditions. The accuracy of these estimates and assumptions by management and its third party valuation specialist can be directly tied back to the fact that management has only been required to record minor valuation allowances through its income statement over time based upon the valuation of each stratum of servicing rights.
49
For more information regarding the estimates and calculations used to establish the ALLL please see Note 4 to the consolidated financial statements provided herewith.
MATERIAL CHANGES IN FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
The Company plans to continue in its growth mode in 2019 led by loan growth from within our newer markets. The Bank is focused on funding the loan growth with the least expensive source of deposits, sale of securities or borrowings. Growing deposits will also be a focus especially in our newer markets. The Bank offers the Insured Cash Sweep (“ICS”) product accessed through the Promontory network of financial institutions which helps to reduce the amount of pledged securities. This has provided more availability for runoff of securities by the Bank if warranted to fund loan growth. Competition for deposits is intense with most competitors offering “special” rates for specific terms.
Liquidity in terms of cash and cash equivalents ended $76.2 million higher as of September 30, 2019 than it was at yearend December 31, 2018. An increase in deposits helped to fund the $312.3 million increase in net loans since yearend 2018. All loan portfolios increased as a result of the Limberlost acquisition with the largest loan growth having occurred in agricultural real estate and commercial real estate portfolios. Consumer real estate and commercial and industrial portfolios also experienced large increases.
In comparing to the same prior year period, the September 30, 2019 (net of deferred fees and cost) loan balances of $1.2 billion accounted for $320.0 million or 38.2% increase when compared to 2018’s $838.7 million. The year over year improvement in all loan categories was made up of a combined increase of 199.2% in agricultural related loans (comprised of 192.8% in agricultural real estate loans and 6.4% in non-real estate agricultural loans). Consumer real estate loans increased by 91.8%, consumer loans by 19.7%, other loans by 36.0% and commercial and industrial related loans by 29.2%. The Company credits the growth not only to the Limberlost acquisition, but also the strong team of lenders focused on providing customers valuable localized services and thereby increasing our market share.
The chart below shows the breakdown of the loan portfolio category as of September 30, for the last three years, net of deferred fees and costs.
September 30, 2017
83,875
63,571
87,239
393,913
119,607
124,165
35,887
6,005
6,555
Total Loans, net
795,205
The following is a contractual maturity schedule by major category of loans excluding fair value adjustments as of September 30, 2019.
After One
Within
Year Within
After
One Year
Five Years
5,516
16,780
136,971
177
5,660
196,000
64,939
30,949
14,372
32,816
220,684
248,828
61,580
57,158
11,463
6,151
32,344
10,973
6,440
50
While the security portfolio has been utilized to fund loan growth for the last three years, additional sources have been cultivated during 2017, 2018, and 2019. The security portfolio increased $22.0 million in the first nine months 2019 from yearend 2018. The amount of pledged investment securities increased by $7.4 million as compared to yearend and increased $8.0 million as compared to September 30, 2018. The difference in the growth and consequently pledged securities, improves liquidity with the additional option of selling unpledged investment securities if needed to fund loan growth or other initiatives. As of September 30, 2019, pledged investment securities totaled $89.2 million. The current portfolio is in a net unrealized gain position of $1.9 million.
For the Bank, an additional $17.3 million is also available from the Federal Home Loan Bank based on current collateral pledging with up to $97 million available provided adequate collateral is pledged.
With the exception of FHLB stocks, carried at cost, which is shown as other securities, all of the Company’s security portfolio is categorized as “available-for-sale” and as such is recorded at fair value.
Management feels confident that liquidity needs for future growth can be met through additional maturities and/or sales from the security portfolio, increased deposits and additional borrowings. For short term needs, the Bank has $123.4 million of unsecured borrowing capacity through its correspondent banks.
Overall total assets increased 41.1% since yearend 2018 and grew 42.1% since September 30, 2018. The largest growth in both periods was in the loan portfolios followed by cash and equivalents. Goodwill also increased with the acquisition of the Bank of Geneva.
Deposits accounted for the largest growth within liabilities, up 37.6% or $349.2 million over both yearend and September 30, 2018 balances. Core deposits continue to drive the increase which provide the opportunity to generate additional noninterest income. This growth aided the increased liquidity position and funded the loan growth for the periods along with usage of purchased Federal Funds for daily borrowings.
Shareholders’ equity increased by $84.1 million as of the third quarter of 2019 compared to yearend 2018, as the acquisition of Limberlost, which included stock in the transaction, was completed on January 1, 2019 along with earnings exceeding dividend declarations in the first three quarters. Accumulated other comprehensive loss decreased in loss position by $4.5 million from December 2018 to an unrealized gain of $1.5 million at September 30, 2019. Dividends declared were the same as the first two quarters at $0.15 per share. Compared to September 30, 2018, shareholders’ equity increased 63.2% or $88.1 million. Profits are higher year-to-date September 2019 than year-to-date September 2018 by $1.9 million with the Limberlost acquisition.
Basel III regulatory capital requirements became effective in 2016. The Bank and Company include a capital conservation buffer as a part of the transition provision. For calendar year 2016, the applicable required capital conservation buffer percentage of 0.625% was the base above which institutions avoid limitations on distributions and certain discretionary bonus payments. For the calendar year 2017, the applicable required capital conservation buffer percentage was 1.25%. For 2018, the capital conservation buffer percentage increased to 1.875%. The total buffer requirement increased to 2.5% for calendar year 2019. As of September 30, 2019, the Company and the Bank are both positioned well above the 2019 requirement.
The Bank continues to be well-capitalized in accordance with Federal regulatory capital requirements as the capital ratios below show:
Tier I Leverage Ratio
10.21
%
Risk Based Capital Tier I
12.45
Total Risk Based Capital
13.04
Stockholders' Equity/Total Assets
13.11
Capital Conservation Buffer
5.04
MATERIAL CHANGES IN RESULTS OF OPERATIONS
Comparison of Results of Interest Earnings and Expenses for three month periods ended September 30, 2019 and 2018
When comparing third quarter 2019 to third quarter 2018, average loan balances with the acquisition of Limberlost grew $294.9 million. This represented a 35.5% increase in a one-year time period. Interest income on loan balances also experienced an increase of $4.5 million as compared to the quarter ended September 30, 2018.
The available-for-sale securities portfolio increased in average balances by $6.3 million when comparing to the previous year while the income increased $287 thousand over third quarter. Fed Funds sold and interest bearing deposits increased in average balances by $93.3 million as compared to the same quarter in 2018 which resulted in increased income of $495 thousand for the current quarter.
Overall total interest income for the quarter comparisons was higher for third quarter 2019 by 44.7% or $5.3 million as to third quarter 2018.
In terms of annualized yield, for the quarter ended September 30, 2019, it was 4.74% which compares to a year ago third quarter ended September 30, 2018 of 4.52%. The following chart demonstrates the value of increased loan balances in the balance sheet mix. The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 21% tax rate in the charts to follow.
Quarter to Date Ended September 30, 2019
Annualized Yield/Rate
Interest Earning Assets:
Average Balance
Interest/Dividends
Loans
1,126,173
5.40
5.16
Taxable investment securities
167,654
1,082
2.58
1.95
Tax-exempt investment securities
32,530
2.32
2.45
Fed funds sold & other
112,961
2.05
1.71
Total Interest Earning Assets
1,439,318
4.74
4.52
Change in Interest Income Quarter to Date September 30, 2019 Compared to September 30, 2018
Total Change
Change Due
to Volume
to Rate
4,477
3,982
372
143
229
(85
(92
5,259
4,511
748
52
Offsetting some of the increase in interest income for the quarter was the increase in cost of funds in 2019. Third quarter 2019 was higher by $2.3 million than third quarter 2018. Since 2018 with the Limberlost acquisition, average interest-bearing deposit balances have increased $278.1 million and resulted in approximately $2.0 million more in interest expense for the most recent quarter. Additionally, interest expense on FHLB borrowings was up $237 thousand in the third quarter 2019 over the same time frame in 2018 due to borrowings taken on from the acquisition. During the quarter, the prime rate has dropped 50 basis points. Management has adjusted deposit rates accordingly.
Interest Bearing Liabilities:
Savings deposits
734,075
2,044
1.11
0.67
Other time deposits
276,793
1,610
2.33
1.53
Other borrowed money
24,582
4.18
1.60
Fed funds purchased & securities
sold under agreement to repurchase
28,947
2.78
2.08
Total Interest Bearing Liabilities
1,064,397
1.55
0.92
Change in Interest Expense Quarter to Date September 30, 2019 Compared to September 30, 2018
1,123
507
616
920
362
205
67
1,292
1,055
Overall, net interest spread for the third quarter 2019 is 41 basis points lower than last year. As the following chart illustrates, higher yields on interest and dividend income did not offset the higher interest expense in the most recent quarter when comparing to the same period a year ago.
Interest/Dividend income/yield
4.24
Interest Expense/cost
0.72
Net Interest Spread
3.19
3.60
3.52
Net Interest Margin
3.85
3.71
Net interest income was up $2.9 million for the third quarter 2019 over the same time frame in 2018 due to the increase in loan interest income and partially offset by higher interest expense, as previously mentioned. As the new loans added in 2018 and 2019 generate more income, management expects the benefits of the Company’s strategy of repositioning the balance sheet to continue to widen this margin as measured in dollars. In terms of net interest margin rate, the Bank recognizes competition for deposits have and will continue to put pressure on the margin which may lead to a tightening.
Comparison of Noninterest Results of Operations - Third Quarter 2019 to Third Quarter 2018
Provision Expense
The ALLL has a direct impact on the provision expense. The increase in the ALLL is funded through recoveries and provision expense. The following tables both deal with the allowance for credit losses. The first table breaks down the
53
activity within ALLL for each loan portfolio class and shows the contribution provided by both the recoveries and the provision along with the reduction of the allowance caused by charge-offs. The second table discloses how much of the ALLL is attributed to each class of the loan portfolio, as well as the percent that each particular class of the loan portfolio represents to the entire loan portfolio in the aggregate. The consumer loan portfolios accounted for the largest component of charge-offs and recoveries for third quarter of 2019 as compared to the consumer and consumer real estate portfolios which comprised the majority of the charge-offs and recoveries for third quarter 2018. The commercial real estate portfolio is currently creating a large impact on the ALLL due to the loan growth.
Total provision for loan losses was $200 thousand higher for the third quarter 2019 as compared to the same quarter 2018. Management continues to monitor asset quality, making adjustments to the provision as necessary. Loan charge-offs were $96 thousand higher in third quarter 2019 than the same quarter 2018. Recoveries were $6 thousand higher in third quarter 2019 as compared to third quarter 2018. Combined net charge-offs were $90 thousand higher in third quarter 2019 than the same time period 2018. Past due loans increased $1.7 million from September 30, 2018 as compared to September 30, 2019. The majority of the change is attributed to the increase of past due balances in the agricultural, agricultural real estate and commercial portfolios.
The following table breaks down the activity within the ALLL for each loan portfolio class and shows the contribution provided by both recoveries and the provision, along with the reduction of the allowance caused by charge-offs. The time period covered is for three months ended September 30, 2019, 2018, and 2017.
Daily average of outstanding loans
831,246
790,397
Allowance for Loan Losses - July 1,
6,683
6,789
6,858
Loans Charged off:
Agriculture Real Estate
103
111
Loan Recoveries:
Net Charge Offs
171
87
Acquisition provision for loan loss
Allowance for Loan & Lease Losses - September 30,
6,755
6,870
Allowance for Unfunded Loan Commitments
& Letters of Credit - September 30,
228
Total Allowance for Credit Losses - September 30,
7,098
Ratio of net charge-offs to average
Loans outstanding
0.02
0.01
Ratio of the Allowance for Loan Loss to
Nonperforming Loans*
173.25
1,399.98%
397.35
*
Nonperforming loans are defined as all loans on nonaccrual, plus any loans past 90 days not on nonaccrual.
The Bank uses the following guidelines as stated in policy to determine when to realize a charge-off of a loan, whether partial loan balance or full loan balance. A charge down in whole or in part is realized when unsecured consumer loans, credit card credits and overdraft lines of credit reach 90 days delinquency. At 120 days delinquent, secured consumer loans are charged down to the value of the collateral, if repossession of the collateral is assured and/or in the process of repossession. Consumer mortgage loan deficiencies are charged down upon the sale of the collateral or sooner upon the recognition of collateral deficiency. Commercial and agricultural credits are charged down at 120 days delinquency, unless an established and approved work-out plan is in place or litigation of the credit will likely result in recovery of the loan balance. Upon
notification of bankruptcy, unsecured debt is charged off. Additional charge-offs may be realized as further unsecured positions are recognized.
Loans classified as nonaccrual were higher as of September 30, 2019 at $3.3 million as compared to $483 thousand as of September 30, 2018. The majority of the increase is in the agricultural, consumer real estate and commercial portfolios.
In determining the allocation for impaired loans the Bank applies the appraised market value of the collateral securing the asset, reduced by applying a discount for estimated costs of collateral liquidation. In some instances where the discounted market value is less than the loan amount, a specific impairment allocation is assigned, which may be reduced or eliminated by the write down of the credit’s active principal outstanding balance.
For the majority of the Bank’s impaired loans, including all collateral dependent loans, the Bank will apply the appraised market value methodology. However, the Bank may also utilize a measurement incorporating the present value of expected future cash flows discounted at the loan's effective rate of interest. To determine appraised market value, collateral asset values securing an impaired loan are periodically evaluated. Maximum time of re-evaluation is every 12 months for chattels and titled vehicles and every two years for real estate. In this process, third party evaluations are obtained and heavily relied upon. Until such time that updated appraisals are received, the Bank may discount the collateral value used.
The following table presents the balances for allowance for loan losses by loan type for nine months ended September 30, 2019 and September 30, 2018.
Balance at End of Period Applicable To:
% of Loan Category
13.68
9.85
17.31
8.17
9.53
12.37
43.25
49.68
11.94
14.98
4.29
4.95
0.00
Off Balance Sheet Commitments
Noninterest income was up $478 thousand for the third quarter 2019 over the same time frame in 2018. The Company has seen an increase in its mortgage production volume and the gain on the sale of these loans was $76 thousand higher for the third quarter 2019 over the same period in 2018. Loan originations on loans held for sale for the third quarter 2019 were $24.7 million with proceeds from sale at $24.8 million for 2019 compared to 2018’s third quarter activity of $13.6 million in originations and $11.8 million in sales. The mortgages sold were both 1-4 family and agricultural real estate loans originated for sale.
The largest fluctuation in noninterest income was in the combined service fee lines, which was $412 thousand higher than the same quarter last year. The increase was largely due to an increase in servicing rights income of $150 thousand and debit card income of $127 thousand.
The impact of mortgage servicing rights, both to income and expense, is shown in the following table which reconciles the value of mortgage servicing rights. The capitalization runs through noninterest income while the amortization thereof is included in non-interest expense. For the third quarter of 2019, mortgage servicing rights caused a net $91 thousand in income, in comparison to a net $17 thousand income for the third quarter of 2018. The higher capitalized additions for 2019 are attributed to a higher loan origination level of 1-4 families combined with a higher mortgage servicing rights value being applied to originations of 1-4 families in 2019 as compared to 2018. For loans of 15 years and less, the value was 1.055% in the third quarter 2019 versus 1.008% in third quarter 2018. For loans over 15 years, the value was 1.259% versus 1.218% for the same periods respectively. The carrying value is well below the market value of $3.0 million which indicates any large expense to fund the valuation allowance to be unlikely in 2019.
Beginning Balance, January 1,
2,299
Capitalized Additions
500
338
Amortization
(329
(264
Ending Balance, September 30,
2,373
Valuation Allowance
Mortgage Servicing Rights net, September 30,
For the third quarter 2019, noninterest expenses were $2.5 million higher than for the same quarter in 2018. Salaries, wages, and employee benefits increased $1.1 million, with the addition of the acquired offices, normal merit increases, increased medical costs and restricted stock expense. Furniture and equipment expenses increased $132 thousand from the prior year primarily due to an increase in depreciation of $83 thousand and maintenance contracts of $48 thousand. Data processing charges increased $118 thousand for third quarter 2019 while advertising increased $351 thousand for the quarter. Other general and administrative expenses were up $542 thousand compared to third quarter 2018. Core deposit intangible increased $140 thousand, loan and collection expense increased $88 thousand and audit and exam fees increased $72 thousand. Miscellaneous NSF checks and other losses decreased $72 thousand from third quarter 2018.
Results overall, net income in the third quarter of 2019 was up $400 thousand as compared to the same quarter last year. The Company has done an exceptional job of growing loans while keeping past dues low. The Company remains strong, stable, and well capitalized and has the capacity to continue to cover the increased costs of expansion.
Comparison of Results of Interest Earnings and Expenses for nine month periods ended September 30, 2019 and 2018
Higher loan balances created the improvement in the interest income for the first nine months of 2019 as compared to the first nine months of 2018. Interest income rose 48.6% or $16.7 million while interest income from loans accounted for the majority of the increase. Contributing to the improvement was an increase in securities income of $489 thousand and an increase in income from Fed Funds sold and interest bearing deposits of $985 thousand over 2018. The change in the balance sheet mix along with the loan growth caused the asset yield to improve by 63 basis points to 5.04% for the first nine months of 2019 compared to first nine months of 2018’s 4.41%. The improvement of the yield was favorably impacted by the $2.0 million reversal of the fair value adjustment from the payoff of the purchased credit-impaired loans as discussed in Note 2.
With each quarter of 2019, the loan growth contributed to the continued improvement in asset yield. The growth factor contribution is shown in the charts which follow.
The average interest earning asset base was $308.1 million higher in first nine months 2019 than the first nine months of 2018, an increase of approximately 29.4%.
57
The yields on tax-exempt securities and the portion of the tax-exempt IDB loans included in loans have been tax adjusted based on a 21% tax rate in the charts to follow.
Year to Date Ended September 30, 2019
1,113,892
5.58
146,085
2,857
2.61
1.91
20,784
489
3.97
75,388
1,206
2.13
1,356,149
4.41
Change in Interest Income Year to Date September 30, 2019 Compared to September 30, 2018
15,257
11,882
3,375
(53
774
(232
(859
627
985
894
91
16,731
11,864
4,867
Interest expense was also higher for the first nine months of 2019 compared to the first nine months of 2018. At $10.9 million, the first nine months of 2019 was up $6.2 million as compared to same time period 2018 or 130.2%.
The average balance of interest-bearing liabilities was higher by $257.4 million in 2019 than the first nine months of 2018. Interest bearing deposits increased $233.1 million while Fed Funds purchased and securities sold under agreement to repurchase increased by $3.3 million. The higher balance coupled with the slight variation of the balance sheet mix, resulted in a 59 basis points increase in the cost of funds at 1.42% for the first nine months of 2019 as compared to 2018’s 0.83%.
Competition has caused deposits to price higher. The change chart on the following page shows the increased cost is only slightly driven more by volume than rate.
708,280
5,577
1.05
0.60
261,729
4,029
1.33
26,035
4.16
29,657
2.37
1.90
1,025,701
1.42
0.83
58
Change in Interest Expense Year to Date September 30, 2019 Compared to September 30, 2018
3,080
1,214
1,866
2,207
1,215
992
753
657
96
151
93
6,191
3,144
3,047
Net Interest Income
Overall, net interest spread figures for the first nine months of 2019 are up from 2018 by 4 basis points and up 18 basis points from 2017. Net interest margin for the first nine months of 2019 is higher than the same period 2018 and 2017. As the chart below illustrates, both higher yields on interest and dividend income, were offset by higher interest expense resulting in total net interest margin up 17 basis points since the first nine months of 2018 and over the first nine months of 2017 by 36 basis points.
4.12
0.68
3.62
3.58
3.44
3.80
3.61
Net interest income was up $10.5 million in the first nine months of 2019 over the same time frame in 2018 due to the increase in loan income even with higher interest expense, as previously mentioned. New loans added in 2018 and 2019 will continue to generate more income, while deposit pressure is expected to continue to increase on the expense side.
59
Comparison of Results of Noninterest Earnings and Expenses for nine month periods ended September 30, 2019 and 2018
Total provision for loan losses was $191 thousand higher for the first nine months 2019 than for the first nine months 2018. While loan growth continued in the first nine months, strong asset quality continued also. The strong asset quality along with only $94 thousand higher net charge-offs offset any need for additional provision above the $410 thousand that was expensed.
830,118
776,828
Allowance for Loan Losses - January 1,
6,784
95
382
272
189
208
426
332
0.04
In comparing past due balances of loans 30+ days, September 30, 2019 balances were $2.5 million as compared to September 30, 2018 balances of $777 thousand. Net charge-offs were also slightly higher at $426 thousand for the first nine months of 2019 compared to the first nine months of 2018’s $332 thousand.
Noninterest income for the first nine months 2019 increased over the first nine months of 2018 by $738 thousand. Combined service fees increased by $833 thousand with increased debit card income of $336 thousand and servicing rights income of $163 thousand. Overdraft and returned check income increased $119 thousand while miscellaneous service fees increased $108 thousand. Gain on sale of loans showed a $59 thousand decrease over the first nine months of 2018. The Company did sell some of its available-for-sale securities in first quarter 2019 and recognized a loss of $26 thousand.
Through the first nine months of 2019, noninterest expenses were $8.4 million higher than in the first nine months of 2018. Of this increase, $1.3 million was third party acquisition related costs incurred with the Limberlost transaction. The effect of an increase of $2.4 million in salaries and wages was combined with an increase of $1.1 million in employee benefits. The addition of the acquired offices, normal merit increases, increased restricted stock expense, increased medical costs and increased employer taxes related to the vesting of restricted stock awards have impacted 2019. Acquisition costs included in these categories were $157 thousand.
Data processing fees were $1.2 million higher than last year with $868 thousand of the increase acquisition related. A seven year contract extension was signed in the third quarter of 2016 which has helped reduce the expense while adding new products and services to better align with our customers’ expectations in the coming years. We have already added additional products in 2019, mainly focused on mobile services and business deposit accounts. Furniture and equipment was $519 thousand higher than 2018. Increased depreciation for new offices and office transformations, along with maintenance costs have led to this expense to increase over 2018.
General and administrative expenses were up $1.7 million over the first nine months of 2018 with $195 thousand incurred from the acquisition. The largest increase was $420 thousand for core deposit intangible. Miscellaneous expenses were $225 thousand more than 2018 with acquisition expenses totaling $37 thousand. Loan and collection expenses were up $116 thousand as compared to 2018. The next largest increase for 2019 was in legal expenses. These two line items on the income statement were up by $154 thousand over the first nine months of 2018 with acquisition expenses accounting for $96 thousand of the increase.
Overall, net income through the first nine months of 2019 was up $1.9 million as compared to the first nine months of 2018. Excluding tax adjusted acquisition costs, net income would have been approximately $14.7 million, an increase of $1.0 million as shown below in the table.
Non-GAAP Reconciliation of Net Income
Net income as reported
Acquisition expenses
1,270
Tax effect
(250
(19
Net income excluding acquisition expenses
14,699
11,926
The Company continues to grow loans while keeping past dues low. The growth in loans has spurred the increase in net interest income that has flowed through to the bottom line. The asset quality has kept loan provision down as the allowance for loan loss remains adequate for the level of credit risk. The opening of the new offices has hampered earnings in the short term; however, the Company remains focused on the long term.
The Company continues to look for new opportunities to generate and protect revenue and provide additional channels through which to serve our customers and maintain our high level of customer satisfaction.
61
FORWARD LOOKING STATEMENTS
Statements contained in this portion of the Company's report may be forward-looking statements, as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements may be identified by the use of words such as "intend," "believe," "expect," "anticipate," "should," "planned," "estimated," and "potential." Such forward-looking statements are based on current expectations, but actual results may differ materially from those currently anticipated due to a number of factors, which include, but are not limited to, factors discussed in documents filed by the Company with the Securities and Exchange Commission from time to time. Other factors which could have a material adverse effect on the operations of the Company and its subsidiaries include, but are not limited to, changes in interest rates, general economic conditions, legislative and regulatory changes, monetary and fiscal policies of the U.S. Government, including policies of the U.S. Treasury and the Federal Reserve Board, the quality and composition of the loan or investment portfolios, demand for loan products, deposit flows, competition, demand for financial services in the Bank's market area, changes in relevant accounting principles and guidelines and other factors over which management has no control. The forward-looking statements are made as of the date of this report, and the Company assumes no obligation to update the forward-looking statements or to update the reasons why actual results differ from those projected in the forward-looking statements.
ITEM 3 QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to loss resulting from changes in interest rates and equity prices. The primary market risk to which the Company is subject is interest rate risk. The majority of our interest rate risk arises from the instruments, positions and transactions entered into for purposes other than trading such as loans, available for sale securities, interest bearing deposits, short term borrowings and long term borrowings. Interest rate risk occurs when interest bearing assets and liabilities re-price at different times as market interest rates change. For example, if fixed rate assets are funded with variable rate debt, the spread between asset and liability rates will decline or turn negative if rates increase.
Interest rate risk is managed within an overall asset/liability framework. The principal objectives of asset/liability management are to manage sensitivity of net interest spreads and net income to potential changes in interest rates.
Funding positions are kept within predetermined limits designed to ensure that risk-taking is not excessive and that liquidity is properly managed. In the event that our asset/liabilities management strategies are unsuccessful, our profitably may be adversely affected. The Company employs a sensitivity analysis utilizing interest rate shocks to help in this analysis.
The shocks presented below assume an immediate change of rate in the percentages and directions shown covering a twelve month period:
Interest Rate Shock
on Net Interest Margin
on Net Interest Income
Net Interest
% Change to
Cumulative
Margin (Ratio)
Flat Rate
Direction
Changes by
Total ($000)
4.23%
20.16%
Rising
3.00%
60,436
18.70%
4.01%
14.03%
2.00%
57,439
12.81%
3.80%
8.00%
1.00%
54,497
7.03%
3.52%
0.00%
Flat
50,916
3.49%
-0.78%
Falling
-1.00%
49,947
-1.90%
3.29%
-6.56%
-2.00%
47,307
-7.09%
3.10%
-11.98%
-3.00%
44,984
-11.65%
The net interest margin represents the forecasted twelve month margin. The Company also reviews shocks with a 4.0% fluctuation with a delayed time frame of 10 months and over a 24 month time frame. It also shows the effect rate changes will have on both the margin and net interest income. The goal of the Company is to lengthen the term of some of the Bank’s fixed rate liabilities or sources of funds to decrease the exposure to a rising rate environment. Of course, customer desires also impact the Bank’s ability to attract longer term deposits. Some movement into the longer term time deposits has occurred. Over the past five year period, the Bank has experienced a decrease in the time balances of our deposit portfolio, and therefore, a loss of term funding. Over the past two years, the Bank has also paid off term borrowings with the last $5 million maturing last year; however, additional borrowings were a part of the Limberlost acquisition in 2019.
The shock chart currently shows a widening net interest margin over the next twelve months in an increasing rate environment with a tightening in a falling rate environment. Cost of funds are at 1.55% for the quarter and 1.42% year to date so the lowest shock of 100 basis points is where the Bank can take full advantage and reprice funds to match the level of shock. Once the shocks are falling over 100 basis points, the cost of funds cannot lower to match and the loss on net interest income continues to build. Since the average duration of the majority of the assets is outside the 12 month shock period, the rising rate environment only shows improvement. The majority of the newer loans added to the commercial real estate portfolio begin with an initial fixed rate period of three to five years whose variable adjustment is outside of the current shock time frame. The Bank continues to adjust its assumptions by including decay rates and key rate ties on certain deposit accounts and continues to review and modify those rates as the index rates change. All shocks are within risk exposure guidelines at all levels. The effect of the rate shocks may be mitigated to the extent that not all lines of business are directly tied to an external index and actual balance sheet composition may differ from prediction.
Overall, the Company must concentrate on increasing loan spreads on variable loans and extend the duration on cost of funds where possible.
ITEM 4 CONTROLS AND PROCEDURES
As of September 30, 2019, an evaluation was performed under the supervision and with the participation of the Company's management including the CEO and CFO, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on that evaluation, the Company's management, including the CEO and CFO, concluded that the Company's disclosure controls and procedures were effective as of September 30, 2019 . There have been no changes in the Company's internal control over financial reporting that occurred during the quarter ended September 30, 2019 that have materially affected, or are reasonably likely to materially affect, the registrant's internal control over financial reporting.
PART II OTHER INFORMATION
ITEM 1 LEGAL PROCEEDINGS
None
ITEM 1A RISK FACTORS
There have been no material changes in the risk factors disclosed by Registrant in its Report on Form 10-K for the fiscal year ended December 31, 2018.
ITEM 2 UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
Treasury stock repurchased the quarter ended September 30, 2019.
Period
(a) Total Number of
Shares Purchased
(b) Average Price
Paid per Share
(c) Total Number
of Shares Purchased as Part
of Publicly Announced Plan
or Programs (1)
(d) Maximum
Number
of Shares that may yet be
purchased under the Plans or
Programs
7/1/2019 to 7/31/2019
—
500,000
8/1/2019 to 8/31/2019
6,569
(2)
25.21
9/1/2019 to 9/30/2019
From time to time, the Company purchases shares in the market pursuant to a stock repurchase program publicly announced on January 18, 2019. On that date, the Board of Directors authorized the repurchase of 500,000 common shares between January 18, 2019 and December 31, 2019.
Shares which were repurchased for taxes on vested stock awards are outside of this program.
ITEM 3 DEFAULTS UPON SENIOR SECURITIES
ITEM 4 MINE SAFETY DISCLOSURES
Not applicable
ITEM 5 OTHER INFORMATION
ITEM 6 EXHIBITS
3.1
Amended Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to Registrant’s Quarterly Report on Form 10-Q filed with the Commission on October 25, 2017).
3.2
Amended and Restated Code of Regulations of the Registrant (incorporated by reference to Exhibit 3.2 to Registrant's Quarterly Report on Form 10-Q filed with the Commission on July 26, 2017).
31.1
Rule 13-a-14(a) Certification - CEO
31.2
Rule 13-a-14(a) Certification - CFO
32.1
Section 1350 Certification - CEO
32.2
Section 1350 Certification - CFO
XBRL Taxonomy Extension Schema Document (1)
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Farmers & Merchants Bancorp, Inc.,
Date:
October 30, 2019
By:
/s/ Lars B. Eller
Lars B. Eller
President and Chief Executive Officer
/s/ Barbara J. Britenriker
Barbara J. Britenriker
Executive Vice-President and
Chief Financial Officer